Friday, February 10, 2012

"President Barack Obama's budget request to Congress on Monday will forecast a deficit of $1.33 trillion in fiscal year 2012 and will include hundreds of billions of dollars of proposed infrastructure spending."

I know where you think I am going with this information, but I'd like to take the discussion in a different direction today.

We have reached an important inflection point in the global financial system that I like to call the Endgame, a term coined by author John Mauldin who literally wrote the book on the Endgame. It has taken on other names such as the final phase of the debt super cycle, the fourth turning (winter), or just the end of a currency system.

We've entered the stage where people are collectively beginning to realize that it is possible for a country to default, meaning not pay back 100% of the money they owe. Investors purchase government bonds because they are risk free and just a slight change in perception of that risk creates a major disruption in the market. This "awakening" was created and is now being stirred by the scene taking place in Greece, which citizens around the world are both reading about and watching on the news on a daily basis. For example, this is what the streets look like this afternoon in Greece upon the announcement of both a minimum wage cut and additional austerity measures announced.

This visual helps bring the concept of a sovereign debt default to life, and speeds up the process of this "awakening." The average citizen who has a regular job and pays little attention to the financial markets is beginning to "awaken" to the idea that sovereign bonds are not 100% guaranteed to return all of their capital.

The importance of this paradigm shift cannot be overstated. The awakening will slowly build until it reaches a tipping point and becomes a mainstream concept such as when a social media website or YouTube video hits the "viral" stage. This took place back in 2007 when a large number of American citizens picked up the phone, called their investment advisor, and asked them if they held something called a "subprime mortgage bond" in their retirement funds. It turned out to their surprise that they did.

Right now we are in the very early stages of this process. For those that have seen the movie "The Social Network," we are at the point when Facebook decided to move from Harvard University to two additional surrounding schools. Still very early in the process, but building momentum.

So what does this mean?

Let's begin with the macro-picture. For the past few decades China, Russia, and other sovereign wealth funds such as the oil rich middle east countries ran a trade surplus and then re-invested those funds directly back into United States and other bonds of foreign countries (such as European countries).

This trend has recently diverged from the normal structure. China is now taking a large portion of their surplus and purchasing assets in the ground such as mining and resource companies. Russia is now doing the same only in a more pronounced fashion.

This has mostly gone unnoticed by the financial world.

While China and some of the larger sovereign wealth funds have begun to understand the big picture and take appropriate action, for the most part the rest of the world is in the dark to what is taking place around them.

For the first time in history, beginning in 1971, we live in a global fiat monetary system. This means that all the currencies around the world are backed by nothing. They have no tangible value beyond the paper they are printed on.

A currency or a government bond today only has value based on "trust" or the "belief" it has value. By turning on the television and viewing what is taking place in Greece we can see what happens when this trust is removed. One morning Greece woke up and found out that the markets no longer "trusted" their ability to pay back the government debt that was borrowed and the value of their bonds promptly moved from 100% to close to zero.

Right now the world trusts United States government debt. This is why we can issue 6 month treasury bills at 0.0% (and sometimes negative interest), and we can issue 10 year government bonds at less than 2% interest.

This means, at the moment, our government has the ability to issue close to an unlimited amount of debt (which is backed by nothing and has no tangible value) and spend it into the real world to purchase real goods and services. China and Russia have picked up on this concept and they are now recycling their "paper" into "things." The rest of the world has not, which has allowed this process to continue.

In the article I said that if a homeowner is $150,000 underwater and will soon be declaring bankruptcy, why would they not put another $20,000 on a credit card before they filed the paperwork?

It seems like a silly concept, but the United States now faces that same decision. Our debt to GDP after 2012 will be at 110%, just slightly below the breaking point where Greece entered free fall.

Obama announced today that as part of the $1.3 trillion borrowed to spend this year, hundreds of billions of dollars will be used for infrastructure work on our country. This is similar to the China strategy of re-investing the overpriced "paper" into under priced "things."

Right now the United States has the ability to issue paper money, backed by nothing, and work on our roads, water lines, bridges, and schools (purchase tangible "things"). We can also use this money to buy tanks, planes, missiles, and aircraft carriers. We could (but probably will not) use this money to invest in technology and medical research. All these would create jobs and stimulate the economy.

I guess what I am trying to say is that if America is going to declare bankruptcy soon anyway, then we should borrow as much money as possible now and try to purchase as many "things" as possible.

If we are going to need to restructure our debt, just like Greece, then what does it matter if we default on $15 trillion in debt, or $20 trillion in debt?

Now that Greece is currently cut off from borrowing in the market I bet you that they would love to be able to go back in time and have borrowed more. They could have spent billions on infrastructure paid by the people that were stupid enough to lend them the money.

The same goes for the US. There are still people that are stupid enough and willing, as insane as it sounds, to lend our government money. There are still people that are stupid enough to hold their wealth in US paper currency backed by nothing, instead of "things" back by intangible value.

One day this ridiculous concept will end. It is already in the very first stages with China's and Russia's awakening. It will slowly move and spread through the world the way Facebook became a household name.

The purchasing power will be transferred to those that purchase "things" first from those that purchase "things" later in the cycle. Please take a moment to stop and think about this process taking place. Throughout history, the world has created an entirely new currency system every 40 years. Our current system began in 1971, and the current awaking taking place around the world will usher in the next monetary structure. Stay tuned, it is going to be the most exciting decade the financial world has ever experienced.

Thursday, February 9, 2012

The mortgage settlement was finally announced this morning after over a year of discussion on how the banks would be penalized for packaging (collecting commission) on loans that they did not own. This is know as fraud and if the average American participated in such an action, they would be immediately sent to prison. The final mortgage fraud settlement has been totaled at $26 billion that the "too big too fail" banks must pay out. Part of the negotiation requires them to pay $2,000 to 750,000 Americans that entered foreclosure over the past few years. Rick Santelli summed it up in excellent fashion this morning:

"The US taxpayers bailed out the banks, which are now using the balance of said proceeds to pay a settlement which amounts to the tune of $2,000 per every person foreclosed on in the past 3 years, in order to assure their vote for Obama, while in the process trampling contact law, as no longer will anyone in America honor anything printed and signed."

Once again, those that chose to stop making mortgage payments, whether because they could not afford to or because they wanted to live payment free, have now once again been rewarded. Those that chose not to make payments on their underwater home and had the opportunity to live payment free for over two full years (the current average time before banks begin foreclosure) will now get a $2,000 check in the mail.

This concept of continuing to reward those that go as deep as possible in debt and then "walk away" can now be seen in parts of the economy beyond the mortgage market. This past week the consumer credit report was released showing a surge in borrowing from the average American. This was touted as bullish for the economy as consumers are now "confident enough to borrow again."

A closer look at the numbers shows something very troubling. The following graph shows the month over month rise in total consumer spending against the rise in total consumer borrowing. Take a look at the last two months of last year (the most recent data) which shows non-existent growth in consumer spending coinciding with a massive increase in borrowing.

This came during the Christmas shopping season when total consumption should be surging. Americans put a tremendous amount of money on their credit cards over this period, but it was not used to increase total consumption (increase total living standards). The borrowed money was used to survive.

The following chart shows with even greater clarity the debt needed to replace the decline in income:

Let's say you are an average American with a home that is $150,000 underwater. You stopped making payments on your home two years ago and have had the double benefit of collecting an unemployment check for 99 weeks, which has recently come to an end. You know that when the bank comes to take your home you will simply declare bankruptcy. Would you not take out another $20,000 in credit card debt knowing you are only months away from bankruptcy? What is the difference between $150,000 and $170,000 in debt you will not be paying after bankruptcy wipes the entire amount away?

This same phenomenon is taking place in students loans that continue to surge month after month. Knowing that there are no jobs available, an enormous number of Americans between 26 - 49 have gone back to school. They have taken out federal student loans that cover the cost of living and the cost of tuition. Under current law you cannot cleanse federal student loans if you declare bankruptcy, but many people at this point do not care. They know that there will be some sort of government bailout in the future if they run into trouble.

Every principle reduction in a student loan (government owned) or mortgage (government owed) is a cost to the US balance sheet. This is now paid for with an increase in the annual deficit, which is now paid for by the Federal Reserve through money printing.

Every day we move closer to the endgame and this politically charged year continues to accelerate our economy toward the edge of the cliff.

Wednesday, February 8, 2012

While you're listening to one of the greatest minds in the financial world today discuss his thoughts on what is ahead, I'll provide you with some helpful visuals to demonstrate the "Currency Wars" taking place around the world in real time.

The first comes from Bud Conrad showing the balance sheet growth for the central banks in Japan, the Eurozone and America. Japan kicked off the most recent party (post financial crisis) to counter the currency strength taking place after the tsunami rocked the markets last year. Then the EU followed up with their breathtaking purchases of sovereign bonds, and now it appears it is Bernanke's turn to once again join the party which he hinted at with his inflation targeting speech this week.

The second graph comes from John Mauldin and shows the staggering separation of real income vs. income that includes government transfers. This shows our country remains tremendously vulnerable to any sort of pull back in spending.

The next chart, from Jim Puplava, illustrates the breakdown of how our government spends money annually. You can see the enormous portion allocated to defense, health care, and pension costs. Bernanke described health care costs this week as "the elephant in the room."

We end with the staggering total federal deficit chart. It is becoming the classic "exponential" graph discussed by Chris Martensen in his now famous crash course.

Excellent discussion this morning with one of the greatest commercial real estate investors in history, Sam Zell. He feels that the government is hurting the ability for homes to find a bottom with their continuous intervention:

On Residential Real Estate:"Rather than let the elements of the business world take care of the problems, we basically stopped the process of creating market clearing. Had we allowed the market to clear without trying to stop reality...we would have a healthy housing market today.It's putting off facing up to reality," Zell said in describing the efforts to halt foreclosures. "The longer we avoid clearing the longer we're going to be living with this problem."

On Commercial Real Estate:

"Commercial real estate still has another couple years to get its act together," he said. "That's literally the point at which all of these extensions and other stuff get cleared out. Becauseotherwise you're going to have a commercial real estate market that doesn't work."

For more on the residential real estate market and where prices are moving in the years ahead, see the complete 2012 Real Estate Outlook.

This forecast is the final piece to the complete 2012 Outlook, released in January.

I have been involved with the real estate industry my entire working life. My first position was with a home builder in Charlotte, NC which eventually took me to Virginia to work for another home builder, which eventually took me back down to Charlotte to help a small group of former division presidents start their own company.

Working with that group led me to the company I am with now, handling a small amount of general brokerage, but mainly focused on larger projects and consulting for banks and their distressed assets.

Being on the front lines of both the run up and the subsequent collapse of the real estate market created an insatiable passion to understand what created the bubble and why it popped. In my process of understanding the greatest bubble in modern history, I also became fascinated with both finance and economics in general, which led to even more study and the creation of this web page.

However, my heart has always stayed with real estate. I have spent thousands of dollars and a tremendous amount of vacation time traveling around the country to commercial real estate seminars (where a large group of people sit in a room and analyze the profit and loss statements for commercial buildings). It is heaven for a nerd like me.

Today, I am asked by friends, family, readers of this site and customers I work with in my business, "where do you see real estate prices going now?" A complete answer takes some considerable time so I have decided to do it here. The following provides both a complete discussion on what creates real estate price movement combined with real time data and an outlook on the future market direction.

We will begin with why real estate prices rose to where they did and why they fell. Understanding the 1980 - 2011 period is critical to understanding where real estate prices will move from here. Then we will look at the two fundamental factors that drive any price: supply and demand. The conversation is meant to open your eyes to factors that are often overlooked when making what may be the largest investment of your life.

Someone took the time to walk me through a large portion of the information presented here back in 2007. After careful consideration, I walked away from a contract on a town home I was ready to purchase in Virginia in foreclosure for $205,000 ($20,000 less than the asking price). The price of the town home has since fallen to below $120,000 and continues downward in one of the most desirable housing locations in the country.

I hope that this information can help others as much as it has helped me. Let's begin our discussion first with how we got here:

In the early 1980’s, a group of the nation’s top financial minds, specifically a firm called Saloman Brothers, went looking for a way to create greater profits off the sale of mortgage bonds (this was most famously documented in Michael Lewis’ first book “Liars Poker”). As with any brokerage house they make their profits based on the volume sold, and they determined that the best way to create additional mortgage volume was to bundle them together and sell them as a larger package of loans that would throw off a monthly income stream to hedge funds, wealthy investors, and the other top banks around the country.

They named this new creation a Collateralized Debt Obligation (CDO) that packaged Residential Mortgage Backed Securities (RMBS). This bundling process became known as securitization.

For two decades the CDO was traded in the background in relatively small size and for the most part went unnoticed. The focus for the markets and banking system was almost exclusively aimed at stocks, mergers, and the tremendous profit potential available from taking the next shining star public. Companies like Yahoo, Microsoft and AOL, the Internet darlings. The Nasdaq, the stock exchange that focused on technology, rocket launched from under 1500 to over 5000 in a three year period to end the 90’s.

It doubled from 2500 to over 5000 in a single year. The public was mesmerized and began piling into to the stock market together as a herd driving prices up toward the stratosphere.

Stocks peaked in January of 2000 and went into free fall, crushing the retirement dreams of many Americans who bought close to the peak.

Americans had pulled their money from the stock market promising “never to return.” However, the 2000’s was a time where baby boomers were at their peak earning years and they needed to find a safe new home for their capital.

Real estate prices had not fallen since 1952 and Americans, with the help of their local real estate agent, could clearly see that it was the safest investment location for their money. The capital that was previously directed toward the stock market began to move toward real estate.

This coincided with an important period of time in global finance. In the late 1990’s and early 2000’s, as impossible as this may seem today, America was running a surplus on its national debt. This surplus, while great for America, provided a problem for other developing countries around the world.

When a country (like China) runs a surplus on their balance of trade (they export more than they import), they have a surplus of money which they need to invest. Up until that point, a major portion of the money was reinvested back into America in treasury bonds that we sold to cover our national debt.

With our new surplus these treasury bonds were no longer available. Who could provide the much needed home for this foreign investment capital?

Enter Wall Street. After two decades of hiding in the shadows, the mortgage backed securities emerged as a new option for global investors seeking a home for captital that also provided a solid income stream. The global surplus began pouring into mortgage backed securities and the bonds issued by giants such as Fannie Mae and Freddie Mac.

The following graph shows the explosive growth in the securitization market from 2000 to 2006:

Wall Street needed more mortgages to feed the insatiable demand for these products. There was a limited supply of buyers that qualified for a standard mortgage (20% down with a high credit score and strong income) so they began to slowly lower the lending restrictions to allow more buyers into the market (greater supply of mortgages sold meant larger profits for the banks).

More buyers led to higher prices. Higher prices led to the illusion that home prices were safe, which led to even lower qualification restrictions. This led to higher prices, and so on and so on. Fannie Mae and Freddie Mac soon joined the party. After realizing they were being left in the cold with Wall Street taking on all the mortgage volume, they too lowered their lending restrictions and began purchasing everything they could get their hands on. All it took was a AAA approval from the rating agencies who were paid (by Wall Street) based on the number of mortgages they approved AAA.

The volume surged and the CEO’s of these companies (banks, Fannie/Freddie/rating agencies) took home bonuses in the tens of millions and they continued to loosen lending restrictions to gain access to even more mortgage securities.

In 2006, loans were being issued at 125% of the value of the home with no verification on a home buyer's income or assets in the bank. That means you if had no job and no money you could purchase a $400,000 home with nothing down and come home from the closing table with $100,000 in your pocket.

All these factors culminated together to create the perfect storm for real estate prices. The following chart shows the long term price of real estate from 1890 to 2006.

At its peak in 2006, the real estate mania was unlike anything the world had ever seen. It appeared as if nothing could go wrong in the market. Next up, we take a look at what followed after prices peaked that year, the darker side of the story.

An asset price rises both for fundamental and psychological reasons. As humans, we tend to move in herds which requires an investor to study more than the raw data of a profit loss statement for a commercial building to determine its future price. The same applies to the decision to purchase the IPO share price for Facebook or a 5-year government bond in Italy.

A computer can look at these investments and based on extensive information, provide you a detailed overview on why an investment is a good or bad decision. However, an investment's fundamental under or overvaluation often times has very little to do with the direction its price will move (in the very short term).

The following outlines a simple flow chart of the herd mentality during the phases of an investment cycle:

This chart can be laid out over almost every secular bull or bear market throughout the last two hundred years. There are tremendous works on human psychology that are beyond the scope of this discussion, but understanding this herd mentality is extremely important before making any investment decision on stocks, bonds, real estate or gold.

When making an investment decision, it first appears counter-intuitive to not purchase something that is popular or even in a state of euphoria. If everyone is buying it, then it means it will most likely go higher. To briefly explain why it is the opposite, let me use a simple example:

You are on an island with 10 people each of whom has $1 dollar to spend. There are 20 apples available to purchase and each apple costs $1. The first 8 people spend their money purchasing an apple, leaving only 12 apples remaining. It would appear to the two remaining island residents that a purchase of apples is a strong investment. They get psychologically caught in the herd mentality and decide to purchase thinking their apple investment can only go higher.

With 10 apples remaining, there is now no more cash available on the island to purchase - they are now fully invested. What happens to the price of the remaining 10 apples? They plunge in value.

Do you see how this concept can be extrapolated into the real world? This shows the importance of sentiment of the market in an investment decision, sometimes known as the willingness of an investor to make a purchase. This is a concept we will return to.

After willingness, the second critical factor in determining the demand is the ability to purchase. Real Estate has become an asset that is almost exclusively purchased using financing (a mortgage). This makes the availability of financing one of, if not the most important, factors in determining the size of the demand pool.

What if the apple vendor allowed apples to be financed at 100%? The price of apples would once again surge as a greater supply of buyers would be able to enter the market. This is a crucial concept I will come back to as we move through this forecast.

In the previous section, we looked at the factors that allowed lending restrictions to loosen and allowed more buyers (greater demand) to enter the real estate market. Now, we must review the darker side of the story: the fall. Let’s get back to where we left off in our story, 2006, at the absolute peak of the mania.

During the run up, it did not matter if a homeowner could not afford to make the monthly payment on the mortgage because they could just immediately put the home back on the market and sell it at a profit. New home buyers would purchase a contract on a home and when it was built and ready to close six months later, they would immediately sell the home for a $50,000 profit.

Many Americans left their jobs to flip real estate for a living. People bought second homes, and then third homes. Money was removed from home equity to finance vacations, cars, and new TV’s. In essence, the herd moved all in, just as the last two residents on the island did when they purchased their apples.

What happened when everyone owned a home and there were no new buyers left to enter the market? Prices suddenly stopped rising and even began to fall. Homeowners without jobs that counted on rising home prices to make their mortgage payments suddenly could not do so.

In February of 2007, the initial shock wave rippled across the world’s media headlines. New Century Financial, which was a massive holder and distributor of subprime mortgages, closed their doors after disclosing massive losses on their mortgage holdings.

Two major Bear Stearns hedge funds closed their doors a week later, citing the same issue. Suddenly there were no buyers for Wall Street's bundled subprime mortgages. Now holding a mountain of mortgage securities stuck on their balance sheet, the large Wall Street banks were no longer buying new mortgages from smaller loan originators around the country.

The financing machine was cut off. Soon, no income/no asset loans were no longer available. Then 100% financing was gone. In a matter of months, Wall Street would only accept the absolute best mortgages (20% down, strong income and strong credit).

This shrunk the total supply of new buyers (demand) tremendously. It came at a time when new home builders were producing new homes as fast as they possible could. These contracts were cancelled when the buyers could no longer gain financing and supply began to flood the market across the country.

Everything that was in motion to create the perfect machine on the way up was now in moving in reverse creating a downward spiral. As prices fell, sentiment toward real estate fell, lending restrictions tightened causing further price declines, which caused sentiment toward real estate to fall further.

In the fall of 2008, the banking system, holding a tremendous amount of subprime mortgages that were under water, had a heart attack and almost completely disintegrated. The collapse of Lehman Brothers froze the entire financial system around the world. Fannie Mae and Freddie Mac went under in August of 2008 and were nationalized. Home prices continued their free fall and the country entered into a depression with jobs disappearing from a nation that was dependent on real estate construction, sales, and financing.

Now, we will look at where we stand today, after six years of carnage in the real estate market from the peak in 2006. We’ll begin with home prices and the most recent data from the various indexes that track them nationally.

CoreLogic showed a 1.4% decline in December, now down 33.7% from the peak.

The Case Shiller index was down .7% in November and is now down 33.5% from the peak.

The LPS House Price Index was down .8% in October and like the previous indexes, it has hit a new post bubble low.

FNC and Zillow also reported month over month declines leading to new post bubble lows.

The state of the home building market can be looked at through building permits, housing starts, and housing completions. All charts run from 1960 through present day.

Total Housing Permits:

Total Housing Starts:

Total Housing Completions:

Every chart shows that every phase of new home development (permits to starts to completions) is currently at depression levels. The numbers are staggering in that our population has grown significantly since 1960 and every chart is still at the trough of all time record lows.

This section has given us an overview of where we stand today in terms of the price structure and health of the home building market. Now, we get to the heart of the conversation: where we move forward from here. As I discussed in the introduction, the foundation of understanding how we arrived here is crucial to understanding where we are headed moving forward. We will re-layer this understanding and foundation with new data to extrapolate out into the future.

Real estate prices, like all other assets, are determined based on supply and demand. However, there are components of supply and demand that are overlooked by almost every buyer and seller in a real estate transaction. We will now cover the entire spectrum focusing first on demand which is comprised of:

1. The Willingness Of A Buyer To Purchase
2. The Ability Of A Buyer To Purchase

Then we will focus on the second portion of the equation, supply, which is composed of:

The sentiment toward housing has fallen drastically since the euphoria peaked in 2006. Home ownership, once a bedrock of every investor's retirement, has become both a major investment loss and a tomb for Americans trapped in an underwater mortgage. The impact of this on sentiment will be magnified by two important demographic groups:

1. Generation Y (Echo Boomers) Born 1980 to 1990
2. The Baby Boomers

Generation Y:

Speaking with many of my friends (early 30’s), those that have not purchased a home now say that they have no intention of purchasing a home. They enjoy the benefits renting offers (maintenance free, flexibility) while they watch homes become cheaper every month. This simple psychological shift will create an enormous change in the home ownership landscape over the next decade.

Generation Y has only known a time of uncertainty in the American economy. Since graduating collegewith a tremendous amount of student loan debt, they have entered a jobs market marred with unemployment levels and job insecurity last seen during the Great Depression. Job uncertainty and unemployment not only impact their psychological decision to make a major investment decision, it also impairs their ability to secure the required down payment. The economy has also delayed both marriage and children for a large part of Generation Y, one of the main reasons for home ownership.

Baby Boomers:

There is another major change occuring in America's most dominant demographic group: the retirement of the baby boomers. Many baby boomers currently live in large homes that once housed their large families. The children have now left the home, leaving them with 4 and 5 extra bedrooms to heat, cool, and clean every month.

A large portion of this important sector of the population has embraced the idea of renting after watching an enormous portion of their retirement disappear along with their home equity. While they are making this psychological shift far slower than their children, (many of whom purchased at the peak and are now underwater) even a small percentage of boomers that choose to rent will have a massive impact on the market.

10,000 baby boomers per day will turn 65 over the next 19 years. These retirement-focused Americans will be looking to downsize and reduce monthly maintenance. Many will choose to do that through renting. A large percentage of these baby boomers purchased their homes before the bubble began meaning they have a significant amount of equity and/or their home is paid off. This allows them the flexibility that the underwater homes do not have to put their homes on the market (increase supply).

Herding Behavior:

As prices continue to fall downward, the sentiment toward homeownership and the home ownership rate will continue to decline. This is how markets form bottoms. Just as with our island residents discussed in the previous sections, when the sentiment toward purchasing apples and the subsequent price of apples falls low enough, it will spark demand from the first brave souls to enter back into the market. This is how a market cycle works. Bubbles tend to run higher and correct further than a fundamental analysis can predict due to the natural herding behavior of human psychology. We experienced the greatest level of euphoria in real estate history and before the market finds its bottom we will have experienced the lowest level in history.

The sentiment toward real estate is extremely important because if no one wants to live in a home, there will be no homes purchased. However, a home provides a basic necessity in life, shelter, something there will always be a built in demand for. As our population grows, at some point new homes will be needed to house these Americans.

Therefore, we must look beyond sentiment and discuss the second factor that determines home buying demand. After someone’s willingness to purchase a home, their ability to make that purchase becomes just as critical.

Imagine you have 100 people living on an island. 70 of them have decided they want to become homeowners. Each one of the 70 ready to purchase makes an appointment with the local bank to apply for a loan. What impact does this simple appointment have on home prices? It is massive.

Let’s say there were 50 homes built on the island and ready for sale at $200,000 each. If all 70 of the willing homeowners are eligible for a loan of $250,000, then you can clearly see what this will do to the price of real estate on the island. There is going to be a bidding war for properties. Homes will almost immediately re-adjust up to the $250,000 threshold.

But what if the lender only approved 35 of the willing buyers and the maximum they were willing to lend was $150,000? If our residents had no savings for a down payment and relied exclusively on this financing to purchase then the price of the real estate would collapse downward. Prices would immediately fall to $150,000 and most likely continue to fall as there would be less buyers (35) than the total stock of inventory (50).

Can you see how important financing is for real estate? This is why lending standards tightening (simultaneously reducing the supply of buyers) in 2007 created the downdraft in pricing across the country.

So with this understanding, we can now review where financing stands today and where it will be going in the future.

After the collapse of the financial system in 2008, the government stepped in and literally became the mortgage market. Almost 97% of homes financed after the 2008 collapse were insured, guaranteed, or financed directly through some form of government entity – The Federal Housing Administartion (FHA), Fannie Mae, or Freddie Mac.

The government’s decision to step in and provide financing for the housing sector has created an artificial floor under housing prices, causing them to first bump higher to begin 2010 with the home buyer tax credit, and then fall slower due to the available government credit.

The reason this floor is artificial should now be obvious. Should the government’s financing be removed (even if just a portion is removed) then real estate prices will collapse downward to the available financing in the free market (just like on our island). If a homeowner had to put down 20% on a home, have excellent credit, and a proven job income for two years strong enough to support the loan (this is how every loan was financed prior to 2000) then the available supply of homebuyers would essentially disappear. This is combined with the fact that many of the buyers in that category would be financially savvy enough to know that they should not be buying and they would wait.

Enter the FHA, an entity created to fund low income housing over 50 year ago, which up until 2007 made up only a small fraction of the total loans financed. They now insure the lion’s share of new mortgages and they offer financing with only 3.5% down.The FHA insurance is now stamped on a loan and then it is housed and stored on the balance sheet of a financial institution with a government backed guarantee. It is the equivalent of the AAA stamping the ratings agencies doled out during the early 2000’s, only the FHA has gone one step further and agreed to cover the costs should there be a problem with the loan (insuring toxic mortgages was formally AIG’s role, a company you may have heard of).

A recent report on the FHA shows that they will need an estimated $10 to $50 billion bailout just to cover current liabilities (if homes were to stop falling today). The FHA has used accounting tricks to create a rosier picture on their balance sheet, such as booking future insurance premium payments immediately as available capital against defaults.

Monthly Payment Costs:

The total loan amount a potential homeowner can receive is only one portion of the complete picture. You must also factor in their ability to handle the monthly payments. Their ability to finance these payments can be determined by looking at two variables:

1. Interest on the loan
2. Home owner’s monthly income

If an American takes out a $250,000 interest only loan (no principle payments) at a 4% interest rate, then their annual interest payment is $10,000 or $833 a month.

What if interest rates were to rise to 7%? Their monthly mortgage payment would then rise to $1,458. This is not important for Americans who have locked in on low rates because their monthly payment amount will not change.

This is important for new buyers entering the market (demand). On our island of 70 people who want to purchase a home, let’s say all 70 can handle a $833 per month mortgage payment. However, if interest rates were to rise to 7% then only 35 could handle the monthly mortgage. If there were 50 homes available priced at $250,000 what would happen to the price of the homes?

The prices would collapse downward to reflect the threshold where new buyers could afford the monthly payment.

Today, our Federal Reserve has short term interest rates held at 0% and they have promised to hold them there through 2014. In addition, they have entered the mortgage market since the financial collapse of 2008 and purchased mortgages directly to help ease the financial system.

This brought mortgage rates to an all time record low rate this past week under 4%.

These ultra low mortgage rates and ability to finance homes has provided an enormous increase to the number of willing homeowners who also have the ability to purchase. It grows the number of home buyers on our island from 35 up to the maximum 70.

Why does this matter?

Home buyers and analysts today have priced in the ability of our government to provide 97% of the mortgages in this country and the ability of our Federal Reserve to lower interest rates forever into their calculations and models on future home prices.

The general public does not understand that the slow down in home price declines is an artificial trap door. If the Federal Reserve and the federal government were forced to move away from the mortgage market in any form then lending restrictions would tighten considerably reducing the number of willing home buyers.

Prices would collapse downward, and lending restrictions would tighten further.

Purchasing a home is a direct bet on the finances of our United States government and the ability of our Federal Reserve to keep rates at zero forever. This website dedicates a tremendous amount of time and research to showing that the United States cannot do this and is heading toward fiscal disaster. As goes our government bond market, so goes our real estate market.

When our government bond market reaches its “Greece” moment we will have to make decisions on the portion of government spending is the most important. I am betting that the American people will prefer to receive a social security and medicare check every month vs. having the government try and keep home prices artificially high.

The numbers reviewed on this site are based on national information. Many of my readers are from outside the United States or they are looking for information about the US housing market as a whole to make macro-economic decisions on the economy and impact of price direction.

For this section, I want to speak to a person reviewing this information that is specifically trying to decide on whether or not to purchase or sell a home vs. renting.

It is important to understand that the motto "all real estate is local" is true.

I wanted to discuss the financing of real estate first because financing a home in today’s landscape will be the same for someone looking in Detroit and someone looking in Washington DC. It should not be this way, but due to our government run mortgage business, it is the world we live in.

This means if you agree with my previous analysis, no matter what city or town you live in,the ability to finance loans over the next few years is going to be a net negative on your investment.

However, when discussing supply, this is not always the case. There are portions of America that experienced far greater bubble-like symptoms during the run up and the enormous supply created still needs to be worked through. In addition to the number of homes for sale in your area, you must also weigh the cost of a monthly mortgage payment against the cost of a monthly rental rate.

When looking at the cost to rent, you must also factor in the future cost to rent when the coming shadow inventory will hit the real estate market (discussed in the next section). To help explain why, let's go back to our original example:

Let’s say you live on an island with 100 people, 70 of which want to live in a home while the remaining 30 are content to live in an apartment community. 35 of those 70 that are willing to live in a home cannot qualify for financing, so they would like to rent. There are currently only five homes for rent, which has driven the cost to rent very high.

However, there are an additional 20 homes in foreclosure, but have not yet hit the market for sale. The island bank is holding them off the market because they do not want to take the write down and have to close their business. The question is, what will happen to the cost to rent a home when these 20 properties hit the market? It will be reduced greatly.

This is why apartments have had a temporary surge in both valuations and rent (a topic I will discuss further in the commercial portion of this forecast). They have the combined advantage of both foreclosed homeowners moving out and the shadow homes being held off the market constricting supply.

Let me give you a real life example of why understanding shadow inventory is important in your rent vs. buying decision:

I live in uptown Charlotte, where rents have surged due to a limited supply of inventory and high demand for rental property. Down the street, there is an enormous condo building sitting almost completely empty. If an investor were to purchase this building and turn the condos into rentals, the supply available in the city would surge. Rents would fall across the board, which would change the outcome of a rent vs. buying decision for someone who did not know this shadow inventory existed.

For reasons I will expand on in the next section on shadow inventory, a large portion of the foreclosed real estate in our country has not yet hit the market for sale, but for this discussion we are looking only at the homes you can see for sale through the multiple listing service (MLS), which can be accessed through any local real estate agent. Once you have your data set you can begin to analyze price direction.

When making a decision to purchase, you must look at the available supply on the market (MLS inventory), the current economic strength of your community, and the future economic strength of your community (when you will be selling).

For example, the housing market in Washington DC is roaring right now. The main source of jobs in DC is the federal government, which as most know has seen a spending surge since the financial crisis hit. Residents of that area have not felt the recession in terms of unemployment. I tell my friends when I visit there that it feels like Miami in 2006.

As a potential homeowner in DC, this may seem like an excellent opportunity to purchase, but you must also factor in what federal spending will look like in 3-4 years when you are looking to sell. If the federal government were forced to cut spending, it would simultaneously reduce the income levels in the DC area. An income reduction would simultaneously reduce the price level which the pool of willing buyers in the area could pay for a home (think of the island). If you believe federal spending will be higher in 4 years and the annual salaries will be larger then it changes your investment outlook.

The same goes for any jobs category. Purchasing in Detroit and counting on jobs related to manufacturing was a losing bet in 2008. However, in small towns in North Dakota right now, real estate is booming due to new jobs related to oil fracking. An investor looking to buy in a market must project out the job growth and income growth in the area years ahead to when they plan to sell.

Once you have a strong understanding of the ability and willingness of the potential buying pool (demand), you must factor that against the current inventory of available homes (supply) in your market, which you can gain access to through the MLS and the services of a local realtor. By looking at how quickly homes are selling per month, you can acess data on how quickly the inventory will be gone in your city. Lower inventory (supply) means higher prices everything else staying equal.

With this understanding, you are ready to look at the final piece to the puzzle: the second half of the supply equation which is unseen to the untrained eye.

The second portion of the analysis on supply focuses on the inventory that is unseen. Driving down your street you may see three homes with a sign in the front yard. This is "visible" inventory, which we discussed in the previous section.

However, there could be two additional homes on your street that have not paid their mortgage in six months, meaning they are delinquent. The bank has not yet completed the foreclosure process, which is why you do not see a sign on the yard.

The foreclosure process moves like this:

Stage 1: Delinquent
Stage 2: Foreclosure
Stage 3: Bank Owned

There are currently millions of homes in America that are at some point of stage 1 and 2. As you have read in the news, a large number of homeowners have been able to live in their homes for years without making a payment before the bank begins the foreclosure process. Why?

When the bank takes ownership of the property through foreclosure and it becomes bank owned, the home will then put it on the market for sale. Often the home will be sold for less than the value of the mortgage, and the bank will then have to write down that amount on their balance sheet. Banks must keep a minimum capital requirement in order to keep their doors open. For this reason, many have let homes sit delinquent for years hoping that property values will return.

These homes sit hidden in the shadows, and have been properly named the "shadow inventory."

So the question is, just how many homes are currently in the shadow inventory pipeline (Stages 1 and 2) and how many more will be coming in the years ahead?

We know that when a home becomes "underwater" meaning that the value of the home is less than the value of the mortgage it is far more likely that a homeowner will default on a loan. In fact, a new form of default has emerged called "strategic defaults" where homeowners have the ability to make payments but choose not to, feeling that they are throwing money into a pit with a home underwater. Strategically defaulting and living payment free in your home for years has become the new cool trend, just like flipping condos in Miami was back in 2006.

There are currently 52 million homes in the United States that are owned and carrying a mortgage. There are another 23 million homes that are owned free and clear (have no mortgage). A large portion of these homes are owned by the baby boomers and will be hitting the market for sale, discussed in 2012 Real Estate Outlook: Demand - Willingness.

Of the 52 million homes that have a mortgage, over 10 million are currently underwater. The FHA has issued 3.5% down payment loans all across the country the past four years at a time when home prices have experienced a steady month over month decline. With only 3.5% equity in these homes at the closing table, only a small downdraft in prices will create an ocean of new properties underwater.

There are currently 4 million homes that are delinquent (not paying their mortgage) and another 2 million that have entered the foreclosure process. These 6 million homes will be entering the third stage, bank owned (REO), and hitting the market like a never ending tidal wave over the coming years.

Behind them are the remaining homes that are underwater that are still making their monthly payment. It is impossible to know how many of the 4 million that are delinquent are part of the 10 million that are underwater, but let's just say that they are all underwater to make the picture rosier. That leaves another 6 million homes underwater homes ready to enter the delinquency stage and begin living payment free.

The numbers are truly staggering, and they are the reason why the Obama administration is desperately trying to put together a refinancing plan to get homeowners back above water and making their monthly payments to the banks.

Remember that home prices are falling today with only the visible inventory entering the market in a slow trickle and interest rates artificially being pushed down by the Fed. Imagine if this shadow inventory hit the market in force during a period when interest rates on mortgages were rising and lending restrictions were tightening.

I envision that scenario taking place in the years ahead, and it will bring the final downdraft in home prices. This final plunge will coincide with the peak level of pessimism in the market. You will hear people say that they will "never purchase a home again."

This period of time will provide the greatest real estate investment opportunity in history.

As I discussed in the introduction, my goal in writing this comprehensive study of the residential real estate market in America was to provide a complete answer to a question I am often asked:

"Where do you see home prices going now?"

This forecast has focused exclusively on the financial considerations that need to be reviewed when making a decision but there are many others such as the pride of ownership, tax benefits, and the security of ownership. The benefits of renting beyond financial considerations involve having maintenance-free living and greater flexibility when making a moving decision.

I will continue to update this site with the most current real estate data combined with my analysis on what it means for future price directions.

Next up, I will discuss the outlook for the commercial real estate prices and the impact that the market will have on the banking system and the economy as a whole.

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